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The Gasoline Price Myth

"If you repeat a falsehood long enough, it will eventually be accepted as fact."

In the financial markets and economics it is a common occurrence that the media and commentators will latch on to a statement that supports a cognitive bias and then repeat that statement until it is a universally accepted truth.

When such a statement becomes universally accepted and unquestioned, well, that is when I begin to question it.

One of those statements has been in regards to plunging oil prices. The majority of analysts and economists have been ratcheting up expectations for the economy and the markets on the back of lower energy costs. The argument is that lower oil prices lead to lower gasoline prices that give consumers more money to spend. The argument seems to be entirely logical since we know that roughly 80% of households in America effectively live paycheck-to-paycheck meaning they will spend, rather than save, any extra disposable income.

"US gasoline prices have dropped for more than 90 straight days. They now average $2.28 a gallon, which is remarkable considering that just a few months ago, some of us were routinely paying $4 and sometimes close to $5.

Not so coincidentally, the US economy surged by 5% last quarter, and does not appear to be slowing down. "

If you read the statement, how could one possibly disagree with such a premise? If I spend less money at the gas pump, I obviously have more money to spend elsewhere. Right?

The problem is that the economy is a ZERO-SUM game and gasoline prices are an excellent example of the mainstream fallacy of lower oil prices.

Example:

• Gasoline Prices Fall By $1.00 Per Gallon

• Consumer Fills Up A 16 Gallon Tank Saving $16 (+16)

• Gas Station Revenue Falls By $16 For The Transaction (-16)

• End Economic Result = $0

Now, the argument is that the $16 saved by the consumer will be spent elsewhere. This is the equivalent of "rearranging deck chairs on the Titanic."

Increased consumer spending is a function of increases in INCOME, not SAVINGS. Consumers only have a finite amount of money to spend. Let's use another example:

Example:

Big John Has $100 To Spend Each Week On Retail Related Purchases

• Big John Fills Up His Truck For $60 (Used To Cost $80) (+$20)

• Big John Spends His Normal $20 Per Week On His Favorite Craft Beer

• Big John Then Spends His Additional $20 Savings On Roses For His Wife (He Makes A Smart Investment)

-------------------------------------------------

Total Spending For The Week = $100

Now, economists quickly jump on the idea that because he spent $20 on roses, there has been an additional boost to the economy. However, this is false. John may have spent his money differently this past week but here is the net effect on the economy.

Gasoline Station Revenue = (-$20)

Flower Show Revenue = +$20

----------------------------------------------------

Net Effect To Economy = $0

Graphically, we can show this by analyzing real (inflation adjusted) gasoline prices compared to retail "control purchases." I am using "control purchases" as it removes retail gasoline sales, automobiles, and building materials from the retail sales number to focus more on what consumers are buying on a regular basis. Related: Obama Kicks The Oil Industry While They Are Down

The vertical orange line shows peaks in gasoline prices that should correspond (according to mainstream consensus) to a subsequent increase in retail sales.

Another way to show this graphically is to look at the annual changes in Personal Consumption Expenditures (PCE) in aggregate as compared to the subsection of PCE spent on energy and related products. This is shown in the chart below.

While the argument that declines in energy and gasoline prices should lead to stronger consumption sounds logical, the data suggests that this is not the case.

The reason is that falling oil prices are a bigger drag on economic growth than the incremental "savings" received by the consumer.

Oil and gas production makeup a hefty chunk of the "mining and manufacturing" component of the employment rolls. Since 2000, when the oil price boom gained traction, Texas has comprised more than 40% of all jobs in the country according to first quarter data from the Dallas Federal Reserve.

The obvious ramification of the plunge in oil prices is that eventually the loss of revenue will lead to cuts in production, declines in capital expenditure plans (which comprise almost 1/4th of all capex expenditures in the S&P 500), freezes and/or reductions in employment, and declines in revenue and profitability.

The majority of the jobs "created" since the financial crisis have been lower wage paying jobs in retail, healthcare and other service sectors of the economy. Conversely, the jobs created within the energy space are some of the highest wage paying opportunities available in engineering, technology, accounting, legal, etc. In fact, each job created in energy related areas has had a "ripple effect" of creating 2.8 jobs elsewhere in the economy from piping to coatings, trucking and transportation, restaurants and retail.

Simply put, lower oil and gasoline prices may have a bigger detraction on the economy than the "savings" provided to consumers.

Newton's third law of motion states:

"For every action there is an equal and opposite reaction."

In any economy, nothing works in isolation. For every dollar increase that occurs in one part of the economy, there is a dollars' worth of reduction somewhere else."

I live in Houston, and the face of fear in 2015 is that oil prices remain low.

Being able to produce goods and services more efficiently is the root cause of all human material progress.

The economy is absolutely NOT a zero-sum game.

Chris Desouza on January 02 2015 said:

The author has a zero sense of math. If the Gas Station loses $20 in revenue, it's not so because of loss in net earnings. The Gas Station also has a lower cost of fuel acquisition. The Gas Station's profit margins will be in line with cost of goods v cost of sales.

Poor reasoning even a 4th grader will recognize as juvenile.

Robert Helbing on January 02 2015 said:

In 2008, that gallon of gasoline cost over $4.00, with nearly all that money going overseas to Venezuela, Nigeria or Angola (our main overseas suppliers). Gas stations and gasoline distributors have tiny profit margins; nearly all the profits of oil sales go to producers.

Today, that gallon costs $2.50, with nearly all that money going to wildcat producers in North Dakota, Texas or Pennsylvania. Your florist gets his cut as before, but the rest goes to pipeline builders, oil rig outfitters, truck drivers, chemists and other American workers.

The economic benefit to the USA is huge. Hence 5% growth last quarter.

Philip Boerger on January 02 2015 said:

How are profit margins for gasoline producers, distributors and retailers affected by price drops?

Zeke Davis on January 02 2015 said:

I own an independent gas station and I can tell you from my experience that our profit has averaged 15 cents a gallon. We have to follow the big boys in pricing and they have always priced their gas at 15 cents over cost. It didn't matter if gas was $4.29 (the highest price we ever had) or $1.97 (our current price). So actually the falling price has helped us as our gross profit percentage is about 7.5% right now, whereas at $4.29 a gallon our gross profit percentage was 3.5%.

Glen on January 02 2015 said:

It is also possible that at lower prices per gallon, more gasoline will be purchased, more vacation trips taken by car - more revenue to hotels, road restaurants, resorts, etc. On the new car front, the case for hybrids and pure EVs may not be as strong - purchases of higher margin SUVs, etc. may increase, benefiting car manufacturers and their supply chains. If lower prices increase demand, some of the excess supply will get sopped up returning equilibrium at some higher price point. Those advocating that fleet vehicles (especially those that return to the same place each day) convert to NG will have a less compelling case if gasoline prices stay low for an extended time.

FC on January 02 2015 said:

What if the delta $ no longer go to imported oil? Then those $'s may be spent on US made goods or services. That is not zero sum, that's a plus for the US economy.

bmz on January 02 2015 said:

Zeke:"We have to follow the big boys in pricing and they have always priced their gas at 15 cents over cost."

Who do you think you're kidding? The OPIS report showed for the week ending December 26 retail fuel margins across the US averaged $0.376, down $0.005 per gallon from the previous week.The 2014 retail fuel margin average stands at $0.218, while the Q4 average is $0.303 and the six week average is $0.310.

Again, the economy is not a zero-sum game. If it were, we'd be living in mud huts and tilling the soil with our fingers and sticks.

John Scior on January 02 2015 said:

As transporting nd distributing goods is a large part of their expense, as this cost drops, not only will consumers see more money in their pocket from direct fuel savings cost, but also indirectly from lower costs of goods that are being transported. View it as a tax. If taxes go up, more resource ( ie money) is being taken from the economy and being diverted to oil producers and distributors instead of in the hands of consumers who would other wise spend it on goods and services they need or desire. People stop having staycations at home and instead drive to the beach and spend money along the way. Instead of this money going outside our economy to foreign oil producers ( and possibly petro-terrorists) it is spent and respent and re-invested into the domestic economy. Its really nice How Houston and texas has benefitted from the 2nd Bush war in Iraq, but the rest of the country has been suffering. who would have thought that such a war would occur ? What state is Bush from, what industry is Richard Cheney in ? Oh, its Texas and the oil industry. Remember , DON'T MESS WITH TEXAS. We've got Jeb waiting in the wings and whose to say another falsified spun up war can be conjured up, irrespective of the detriment to the rest of the nation and the economy.

rammer on January 02 2015 said:

The positive economic effect of lower energy prices is that part of the price of many products is the energy needed to make them. Corn, plastic, and aluminum are good examples of products where the majority of the cost of a finished product is the energy needed to make it.

As you argue, it is not Joe Sixpack who gets the economic benefit right away, instead it is the long haul truckers, farmers, and machine shop owners who get the initial benefit, and then spend it on other priorities like repairs, equipment, or an additional employee.

Gaelan Clark on January 03 2015 said:

You are calculating profit by the gas station improperly. A $20 gas transaction leaves very little profit for the gas station....most of that money is taxes and money back to the commodity producer. So in fact when that $20 is spent at the flower store...the owner makes most of that and less is paid in taxes.
so you are wrong on the gas price being zero sum.

Wardawg02 on January 04 2015 said:

Lance,

Did you have any chance to take MacroI in school?

-concerned reader

Balu on January 05 2015 said:

When prices of oil goes down, I am sure that at some point of time, the freight charges, be it Rail/road/air will also come down leading to a drop in the cost of products. Every product manufactured needs energy. A fall in the input cost of commodities will definitely help the end user. Unless of course the benefit is not passed on.
Isn't that the actual savings finally seen by the end consumer? If the economy was sustainable a few years back with low oil prices, why are we concerned now that dropping oil prices will hurt the economy? Yes, it may hurt the economy of oil producing nations (a minority) but definitely not the economy of oil deficit nations who rely only on imports.

Bernd on January 06 2015 said:

Pretty pathetic piece of economic analysis. The economy is not a zero-sum game and it is dynamic instead of static.

If a gas station makes $1 less on a gallon of gas it is because their cost of gas was likely $1 less. If the oil company is charging a dollar less, it is because their costs were likely also lower.

When oil prices drop, oil and gas companies also benefit from elasticity effects. This means that when gasoline is cheaper people drive more. So the oil company may make less per gallon, but they sell more gallons (the first example of a dynamic effect).

Now look at the effect of lower energy prices on the entire economy that uses energy as a input. I am in the tech business. Lower natural gas prices mean lower costs of electricity, which means at the end of the day that cloud computing companies like Amazon can cut prices faster. This makes cloud computing cheaper, which accelerates the adoption of cloud computing (a second dynamic effect). If it is easier for people to adopt cheap cloud services then more businesses will start and succeed (a third dynamic effect).

What about car companies? With cheaper gas prices more people can afford to drive a car so more people will buy cars. So car companies make more cars, employ more people, buy more parts to make cars from companies who then employ more people. Layers and layers of positive dynamic effects.

Separate fracking for natural gas from fracking for gasoline. Fracking for natural gas has driven natural gas prices so low that entire classes of manufacturing that uses natural gas as an input are coming back to the USA. So this is a case of low natural gas prices directly causing job growth.

No the economy is not a zero sum game. Anyone who thinks so is an economic idiot and probably a socialist.

Ozair on January 07 2015 said:

The lower oil prices will certainly hurt the economies of U.S Shale producers as most of them are packing up. the number of rigs are down and certainly there will be a huge impact on the Capital expenditure plans for these Companies as they cant sustain to make huge capex. resultantly impacting the economies of heavy metal industries etc. further, there is a fear of job cuts in oil industry as many oil companies specially in exploration companies might contemplate to do that and that will put a great strain on US economy due to unemployment.

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